Renegotiating NAFTA

Summary

Global Impact Strategies (giStrat.com) applied giCompute, an advanced decision analytics platform, to simulate the renegotiation of the North American Free Trade Agreement (NAFTA). President Trump has stated that one of his first goals is to renegotiate NAFTA to provide more benefits to American workers, particularly manufacturing laborers.[1] President Trump has stated that if negotiations are not favorable, he is willing to withdraw from the agreement.[2] Below are the key findings of our analysis regarding the outcome of NAFTA negotiations:

The U.S. government will enter negotiations seeking a substantial rebalance of trade policies that will be perceived as highly unfavorable by Mexico and Canada. The most achievable negotiated outcome is a slight rebalance to NAFTA policies, more amenable to Canada and Mexico.

The Trump Administration will seek to eliminate or substantially reduce the Mexican VAT (value-added tax) and, to a lesser extent, the Canadian GST (goods and services tax). President Trump will seek to reform the dispute mechanism procedures of NAFTA to favor U.S. companies while protecting the U.S. government from foreign lawsuits. His team will seek to enhance rules favoring American-made goods for purchase by the U.S. government; increase the de minimis for the value of shipments before they face customs revisions; enhance shared labor standards; and enhance shared environmental regulations.

Canada and Mexico prefer to maintain the current VAT and GST levels along with the current threshold for rules of origin. giCompute utility calculations indicate that the cost to Mexico and Canada is much higher if they fail to reach an agreement with the United States.

The risk of a trade war between Canada, Mexico, and the United States is higher than any time in recent history. However, giStrat assesses the chances of this occurring are moderately low. Neither Mexico nor Canada would seek a direct trade war if the Trump Administration takes a hard stance toward a substantial protectionist rebalance, as they have substantially less leverage than the United States in the negotiations. Mexico and Canada will be compelled to diversify their trade relations with other countries outside of North America.

Canadian Prime Minister Justin Trudeau might maintain a harder position closer to the current NAFTA terms given Canada’s relatively strong negotiation position. Mexican President Enrique Peña Nieto is more likely to bend to U.S. demands on trade, while seeking to strengthen trade ties outside of North America.

Background

NAFTA: The Good, the Bad, the Ugly

giStrat analytics estimated the likely outcome of a renegotiation of NAFTA. Better trade deals can theoretically improve worker wages, but the actual effect on overall employment is difficult to measure. Numerous reports have shown that increased imports do not cause high unemployment, and that trade restrictions do not definitively increase employment.[1] These same studies suggest that reducing imports to a country can negatively affect the volume of exports from that country when trade partners see tariffs or other barriers as coercive. These tit-for-tat competitions in trade policy can set off a trade war.[2] Heading into NAFTA negotiations, the Trump Administration is walking a fine line between negotiating a better trade deal for Americans and setting off a trade war that could simultaneously hurt the economic interests of the United States, Canada, and Mexico.

NAFTA was signed in 1994 by Canada, Mexico, and the United States. The treaty eliminated most tariffs between the three countries, with the exception of some agricultural exports. NAFTA signatories took nearly fifteen years to implement the agreement, introducing policies piece-by-piece from 1994 to 2008. The trade agreement enhanced intellectual property enforcement, improved transportation and communication infrastructure linking the three countries, and eliminated trade barriers in the manufacturing, services, and agricultural sectors.

Critics of the deal believe the agreement hurts American workers. The American Federation of Labor and Congress of Industrial Organizations (AFL-CIO) blames the agreement for the transfer of 700,000 American manufacturing jobs to Mexico in the past twenty years. The Trump Administration aims to create jobs through better trade deals, citing the $50 billion trade deficit with Mexico and the $13 billion deficit with Canada as evidence the United States must renegotiate trade policies with its neighbors.

Advocates for NAFTA note the agreement has protected the United States, Canada, and Mexico from overseas competitors. The U.S. Chamber of Commerce credits NAFTA with increasing American trade in goods and services with Canada and Mexico from $337 billion in 1993 to $1.2 trillion in 2011. A 2014 study indicated U.S. welfare increased by .08% as a result of NAFTA, and trade between the countries increased by 41%.[3]

Understanding American, Canadian, and Mexican Preferences on NAFTA

The Trump Administration may be less concerned about the rise in the price of goods associated with a withdrawal from NAFTA than with losing political support. President Trump was recently asked how his supporters would respond if tariffs lead to higher prices of goods. He answered: “I see people buying five dolls for their daughters, maybe buy two dolls for their daughters. But I also say that we’ll start making the product at home.”[4] President Trump and some of his advisers want to increase wages and manufacturing jobs simultaneously, while appealing to constituents who blame NAFTA and free trade deals for poor economic conditions.

Key White House advisers, including Peter Navarro, Wilbur Ross, and Steve Bannon, hold strong protectionist views. Peter Navarro may influence Trump’s direction as the head of the newly created National Trade Council.[5]Wilbur Ross, likely to be confirmed as U.S. Secretary of Commerce, coauthored a report with Navarro on Trump’s economic plan. The two hold similar positions.[6],[7] On the other side of the spectrum, more free-market minded individuals, including Gary Cohn, the incoming director of the National Economic Council, support less protectionist policies.[8] Despite their differences, empirical simulations show that many of Trump’s advisers, protectionist and traditionalist alike, would support a U.S.-led renegotiation of NAFTA. The Trump Administration has the support of industrial, automotive, and food and agricultural workers. Trump also has the support of small farm owners.

Canadian Prime Minister Justin Trudeau and Canadian Ambassador to the United States David MacNaughton publicly stated that Canada is willing to renegotiate NAFTA.[9] Mexican President Enrique Peña Nieto also publicly stated that Mexico would be open to renegotiating NAFTA.[10] However, officials in Mexico and Canada reportedly met to discuss NAFTA before publicly stating their willingness to renegotiate.[11] As the United States’ largest export markets, Canada and Mexico hold significant bargaining power.

Analysis

Results: Projected Positions and Outcome Pathways

giStrat analysts ranked the known preferences of key stakeholders across eight determining negotiation factors deemed most significant from the research literature: (1) the value-added tax (VAT); (2) rules of origin; (3) dispute resolution reform; (4) U.S. government procurement; (5) de minimis values; (6) standardization of labor rights; (7) environmental regulation standards, and (8) effect on the economy. Using this process, giStrat estimated the utility value each country and relevant stakeholders and groups placed on the variety of potential outcomes related to NAFTA. The analytics estimate negotiation outcomes and potential for a trade war.

Outcome Pathways:

Below are the defined outcomes and the factors associated with each of those outcomes.

Determining Factors

Valued-Added Tax (VAT): Mexico imposes a value-added tax (VAT) on most sales. The VAT also applies to sales of foreign products. The VAT rate is 16 percent, but it varies from 25 to 160 percent, depending on the product. The VAT has concerned the U.S. government, because Mexico’s Tax Administration Service provides insufficient notification of procedural changes, interprets regulations inconsistently, and enforces Mexican standards and labeling rules unevenly.[1] The VAT became an issue in the most recent election as President Trump called NAFTA “the single worst trade deal ever approved in this country,” and suggested that he would put in place a “big border tax.”[2]

Goods and Services Tax (GST): The GST is Canada’s version of Mexico’s value-added tax (VAT). Canada’s average GST rate is five percent, significantly lower than Mexico’s VAT average of 16 percent.[3]

Rules of Origin: Rules of origin are the set of rules that define where a product originated. A product’s origin determines the duties, tariffs, or restrictions levied on the product. President Trump may attempt to update the rules of origin in order to benefit the United States. However, Canada and Mexico may not agree to a rule change. Instead all countries might agree to update the rules of origin to protect the region as a whole against Asian manufacturing. Trump’s team is pushing for changes in the rules to reduce imports from China, according to Mexican sources.[4]

Dispute Resolution System: NAFTA has a mechanism whereby disputes between foreign investors and governments can be resolved through international arbitration. As NAFTA now stands, Canadian or Mexican companies can sue the U.S. government via legal disputes with U.S. companies. The Trump Administration could seek to change the investor dispute resolution system to limit Canadian or Mexican companies’ ability to sue the U.S. government.[5] They might also seek to strengthen American investor rights in Canada and Mexico.

U.S. Government Procurement: Chapter Ten of NAFTA currently requires each member country to not discriminate against suppliers of goods and services from other NAFTA countries in public sector procurement projects. This rule conflicts with the Buy American Act, which requires that all goods for public use be produced in the U.S., and public use manufactured items must be manufactured in the U.S. from U.S. materials.

Mexican and Canadian goods are exempt from the Buy American Act rules because of NAFTA. President Trump’s advisers are likely to target these exemptions and attempt to remove them in order to spend money on American products for federal projects. Removing the exemption is likely to prove contentious.

De Minimis: NAFTA contains a provision that allows goods to qualify as originating in the US, Canada, and Mexico if the components are not more than a certain percentage of the transaction value of the goods. There are variations in the de minimis calculation depending on the type of good.[6] It is possible that the U.S. will seek to raise the de minimis value.

Labor Rights: Currently NAFTA contains limited provisions for standardized labor protections but almost no mechanism for enforcing labor standards. This is part of what keeps labor costs down in Mexico. The United States may try to include stricter labor protections in a renegotiated NAFTA.

Environmental Regulation: Like labor rights, NAFTA has limited enforcement mechanisms for environmental regulations in Mexico. This means that Mexican manufacturing has an advantage in skirting regulations that are more strictly enforced in the United States. Critics of NAFTA say this creates an unfair playing field that disadvantages American manufacturing. The Trump Administration may attempt to introduce more standardized environmental protections that level the playing field between Canada, Mexico, and the United States.

Effect on Economy: Leaders from opposite sides of the political spectrum—including President Trump from the right and Senator Bernie Sanders from the left—have forced the issue of free trade to the forefront of public policy. In our age of rapid globalization, there is a tradeoff between cheaper goods and depressed wages. We do not yet know whether better trade deals will resolve this tension. Although NAFTA is an imperfect trade deal, the principal purpose of the agreement is to shore up the North American trade bloc from overseas competition. On balance, most economic studies indicate NAFTA has moderately benefited all three countries. Despite strong criticisms of NAFTA by President Trump, most administration officials do not seek to end the deal completely and prefer to renegotiate and rebrand for more favorable terms.

Approximately 34% of American exports go to Canada (18.5%) and Mexico (16%), making them the top two trading partners to the United States, with China in third[7].The negotiations could result in a rebalance of the trade deficit with the United States, in which case American net exports increase and demand for American manufacturing jobs increases. However, if the NAFTA signatories do not reach a compromise for a revised trade deal, they run the risk of starting a trade war. This would prove catastrophic for the national GDP of all three countries. The three countries must also consider the secondary effects of increased tensions within the bloc, including neighbors’ improved bi-lateral relations with overseas competitors such as China.

Some economists and financial analysts label Trump’s trade policy as import substitution, an economic tactic aimed at replacing cheaper foreign products with less desirable domestically produced goods through tariffs and other trade barriers.[8] This would be part of the Trump Administration’s attempt to reduce dependency from the outside world while saving the American manufacturing base from offshoring. Whether this policy will work is unknown and beyond the parameters of this study.

Estimated Payoff Results:

Below is a table of the estimated utility payoffs score (net benefits) for each of the major groups and stakeholders involved in NAFTA renegotiations.

Definitions

Payoffs: The scenario closest to current reality (status quo) is indexed at a score of zero. Any payoff score greater than zero is a better option than the status quo, while any payoff score less than zero is worse than the status quo. giCompute generates these group and stakeholder payoffs (i.e. utility value or net benefit) by first capturing stakeholder preferences across the factors defined in the issue setup. giCompute then sifts through the full combinations of possible payoff scores in order to identify the true payoff that corresponds to each scenario outcome.

Egalitarian Outcome: The egalitarian outcome calculates the average payoff of the stakeholders across the various outcomes. It assumes all the stakeholders are equal in vote or influence.

Influence Driven Outcome: The influence driven outcome is a calculation of the aggregate payoffs for each outcome when considering the weighted influence of the various stakeholders and groups.

Cost of Friction: The relative cost of friction is defined as the degree of disagreement between the various stakeholders and groups across the scenarios.

Outcome:giCompute simulation results indicate the United States will likely seek a substantial rebalance that will be viewed as highly unfavorable by Mexico and Canada. The Trump Administration will seek to eliminate or substantially reduce the VAT (value-added tax) and reform the dispute mechanism procedures, favoring U.S. companies while protecting the U.S. government from foreign lawsuits. The Trump Administration will also seek to enhance rules favoring American-made goods for purchase by the U.S. government, increase the de minimis for the value of shipments before they face customs revisions, enhance labor standards, and enhance standardized environmental regulations. giCompute results indicate that neither Mexico nor Canada will instigate a direct trade war if the Trump Administration takes a hard stance toward a substantial protectionist rebalance, as they have significantly less leverage than the United States in the negotiations.

Canada and Mexico prefer to maintain the current VAT levels and the current threshold for rules of origin. giCompute utility calculations indicate that the cost to Mexico and Canada is much higher if they fail to reach an agreement with the United States. Our results indicate Mexico and Canada will be highly dissatisfied with a trade rebalance that favors the United States and might seek alternative trade deals with overseas competitors such as China.

Strengths: Maintaining the status quo with the two largest markets for U.S. exports during a turbulent and uncertain time brings a degree of stability, which can help keep markets and businesses stable and maintain the large amount of investment that comes into the United States. Renegotiation could correct some of the ills associated with globalization and free trade and bring about better outcomes for some of those who were harmed by the original agreement via labor protections. Labor representatives argue that the deal benefits corporations to the detriment of workers.

Weaknesses: If the negotiations with Canada and Mexico fail, the Trump Administration risks a backlash from consumers who will likely bear the burden of increased prices of goods ranging from gas to agricultural products.

Opportunities: It is possible that the United States can improve NAFTA less drastic and disruptive means than a major renegotiation. Canada and Mexico’s stated willingness to renegotiate could open the door for other opportunities to work with the countries to improve some aspects of the trade deal. During former President Obama’s campaign, he stated that he would renegotiate NAFTA in order to include more environmental and labor protections.[9] There is room for improvement, but full renegotiation may not be the most effective way.

Threats: Unexpected circumstances could lead President Trump to withdraw from NAFTA, which most economists agree will have a devastating effect on the U.S. economy.[10] Renegotiating NAFTA also has the potential to disrupt the economies of our two largest markets for exports, which would be disastrous for all parties involved. An economic crisis would lead to higher prices for consumers, fewer jobs, capital flight, and slower growth.[11]

Current Landscape of Stated Position on NAFTA

Projected Landscape of Positions on NAFTA

The projected landscape indicates that most of Trump’s Administration will push for a substantial rebalance with the support of workers from the automotive, industrial, and food and agriculture sectors. Canadian Prime Minister Justin Trudeau might maintain a harder position closer to the current NAFTA terms given Canada’s relatively strong negotiation position. Mexican President Enrique Peña Nieto is more likely to bend to American demands on trade.

Friction and Convergence Between Stakeholders

Degree of Convergence: The charts below show the range of utility payoffs for the stakeholders across the various defined scenarios. Misalignment of the bars and colors within the bars indicates disagreement between stakeholders. Alignment indicates agreement.

The chart above reveals disagreement within the Trump Administration between the traditional free-market advocates such as Gary Cohn and more protectionist advisers like Wilbur Ross, Peter Navarro, and Steve Bannon. It indicates misalignment between the owners of capital in the automotive, agricultural, and other consumer goods sectors seeking cheaper labor. Canada and Mexico will also substantially disagree with the United States as the Trump Administration seeks to significantly change the terms of trade with its neighbors.

Reliability Testing: Monte Carlo Simulations

Description: The graphs below depict results from the Monte Carlo simulations. The Monte Carlo method uses repeat random sampling to solve problems or obtain numerical results. giCompute usesMonte Carlo simulations to allow users to test how the outputs react to randomly generated inputs over many trials. Users can direct the platform to run between one and forty randomized alternative futures. Users can also determine how many factors and factor options to randomize. The chart shows the percentage the model results in each outcome over the specified number of simulations. An outcome is more likely when it has a higher win percentage.

Results: giStrat conducted Monte Carlo simulations across 40 alternative futures with a 90% variance probability and a change of ±10% in stakeholder influence. In each simulated alternative future, we randomized two factors and one factor option while keeping the remaining factors constant. The results indicate that President Trump and his advisers will seek a substantial rebalance in NAFTA terms. The likelihood of an escalating trade war is possible but unlikely.

Sensitivity

Methodology

About the giCompute Decision Analytics Platform

giStrat applied its analytics platform, giCompute, to estimate game theory-based benefits (payoffs) of the major groups and actors regarding NAFTA by ranking their known preferences across eight factors deemed important to negotiations. We estimated the overall utility values of the various factions and stakeholders on the potential outcomes related to NAFTA talks. We estimated the likelihood of a renegotiated NAFTA, one of Trump’s main policy goals. giCompute incorporates the principles of game theory and decision science to calculate the positions leaders adopt and, more importantly, the impact of their actions on the outcome.